Tax-Efficient RRIF Management

When a dollar comes out of a RRIF, it gets hit with the full tax wallop. It doesn’t matter where that buck originally came from: dividends, capital gains, interest income. It’s all the same to the tax folks.

But there are still some potentially money-saving tax strategies available to you. Many  retirees will have two types of savings – their RRIF and a non-registered investment portfolio. The key is to manage the two for maximum tax efficiency.

For starters, here’s a brief rundown of the tax implications of the three basic types of investment income:

Interest: Interest is the most common source of investment income in Canada. It can be earned from bonds, GICs, CSBs, deposit accounts, and other interest?bearing investments. Interest income receives no tax advantage at all. You pay at your marginal rate, meaning at the rate you pay on the last dollar you earn.

Dividends: These are payments made to holders of common or preferred shares of corporations or mutual funds. Payments from taxable Canadian corporations are eligible for the dividend tax credit if held outside a registered plan such as a RRIF. This significt reduces the effective tax rate.

The dividend tax credit is based on the reasoning that this income has already been taxed in the hands of the company at the time that it was earned, before being paid out to investors. So taxing the investor fully would amount to double taxation. To calculate the dividend tax credit, you must first “gross up”, or increase, the amount of the dividend payment by 25 percent. You then claim a tax deduction for 13.3333% of the grossed?up amount.

Capital Gains: Only 50% of your profit from the sale of shares or distributions from equity mutual funds is included in your income for tax purposes. The other half is effectively tax?free, making capital gains an attractive income option.

Using this knowledge, the key to effective tax management is to distribute your assets carefully between registered and non-registered plans. Generally, this means keeping interest-bearing securities, bonds, GICs, and the like inside RRIFs, and those earning dividends and capital gains outside your RRIF. In 2001, for example, a top-bracket Ontario taxpayer keeps about $53 of every $100 in interest income, with the rest going to tax. If the same $100 is received outside a RRIF as dividends, the taxpayer would keep almost $69 — a 30% after-tax difference!

If the money were earned as capital gains outside the RRIF, the advantage would be even greater. The top-bracket taxpayer would retain almost $77 out of every $100 earned.

Based on this knowledge, review your RRIF and your non-registered investments. If you’re holding bonds, GICs and the like outside the RRIF, swap them into the plan and take out an equal value in stocks, equity mutual funds, REITs, or whatever you have that has some tax efficiency.

Swaps (also called switching) are perfectly legal, as long as you follow the rules. If you’re not sure exactly how to proceed, ask the company that’s administering your RRIF to help.